Big Tobacco Takes Its Last Drag as Economic Change Looms

Why economics are shifting in the tobacco industry.

NEW YORK ( TheStreet) -- Investors addicted to dividend-paying cigarette stocks such as Philip Morris ( PM), Altria ( MO), Reynolds American ( RAI) and Lorillard ( LO) may have to kick their habit.

Cigarettes are known in economic circles as an inelastic product. Because they are highly addictive, their demand doesn't vary with economic change and hence large tobacco conglomerates have little incentive to alter their pricing. The dividend paying industry benefits from a product with a low price elasticity, a term coined by Alfred Marshall, the founder of modern economics.

In fact, cigarette pricing is so steady tobacco is excluded in most surveys of inflation. Now, amid the rise of smokeless tobacco and the electronic cigarette, some on Wall Street are beginning to worry that the tobacco industry has lost some of its deadly economic force.

Cigarette price elasticity has deteriorated sharply in recent years among the Big Three U.S. manufacturers, according to a survey published by Citigroup on Thursday.

"While the U.S. cigarette manufacturers continue to assert that cigarette price elasticity has remained relatively stable over the last 20 years, our math indicates that price elasticity in U.S. cigarettes has in fact deteriorated notably over the last decade," Citigroup analysts wrote.

The long-term price elasticity of the cigarette industry has ranged from -0.3 to -0.4 in 10-year averages, however, Citigroup found that price elasticity in the U.S. was -0.8 in 2012, a dramatic change. The falling stickiness of cigarette pricing is all the more troubling as consumption trends signal a long-documented decline in the U.S.

Citigroup cited rising promotions for cigarettes, smoking restrictions in the U.S. and new substitutes such as smokeless cigarettes as reasons for the fundamental economic shift of the industry.

The analysts believe the earnings profiles of Altria and Reynolds American are relatively insulated from a continued deterioration in the fundamentals of the cigarette industry, given their exposure to smokeless tobacco. Lorillard, which generates nearly 100% of its earnings from cigarette products, could be more at risk.

All is not lost for investors who aren't in a rush to kick their addiction to Big Tobacco's juicy dividends and their stable share prices through the economic tumult of recent years.

The price premium of Altria-owned Marlboro, the leading cigarette brand by market share in the U.S., has increased relative to Copenhagen, the second largest chewing tobacco brand in the U.S, over the past four years. As cigarette consumption falls by mid-single digits annually, smokeless tobaccos have seen a proportionate amount of growth.

In comes a new economic term for Big Tobacco investors to chew over: the cross elasticity of demand.

Basically, people need their fix whether or not politicians allow smoking in bars, offices, athletic venues and state land.

As consumption and pricing of cigarettes faces structural economic change, smokeless tobacco products such as chew and its Swedish iteration, Snus, are direct beneficiaries. Those segments of the market are seeing growth and the prospect of margin expansion.

"We believe that attention should be paid to the deteriorating price elasticities in U.S. cigarettes. However, we don't think it's yet cause for alarm, given the still-wide gaps that exist between the margins for smokeable tobacco offerings," Citigroup noted.

E-cigarettes, however, could undermine the cross elasticities that Big Tobacco firms enjoy between traditional cigarettes and smokeless tobacco. " We do not believe that e-cigarettes are yet having an impact on the longer-term interaction between traditional cigarettes and MST Moist Smokeless Tobacco , but over time we do not rule out that possibility," Citigroup concludes.

A quick note to consider alongside Citigroup's compelling analysis: Many of the economic shifts they have tracked appear to be a consequence of changing legislation such as smoking restrictions and some states' adoption of extremely burdensome taxes.

Changing political winds could continue to cut against Big Tobacco. Consider that it was only about 10-months ago that states such as Washington, California and Colorado voted to legalize marijuana, a previously illegal product. The prospect of a groundswell of support for the legalization of marijuana nationally could further undermine both the price elasticities and the cross elasticities that have been a staple of Big Tobacco for decades.